Global Equity Allocations

What is an appropriate foreign stock weighting for a US investor?

Not many decades ago it was nearly impossible for individual investors to buy foreign equities.  Barriers to investing have fallen away enabling new investing opportunities.  Global capital markets have expanded and technological and financial innovations have empowered investors to make informed decisions about these new markets.

The last 50 years have changed how an investor can view the world.  However, there are still some restrictions to foreign capital flows, most notably the Chinese A shares market, many Indian companies and of course those restrictions in place due to country conflicts or embargo.

Home country bias and familiarity bias.

Home country bias is the tendency for investors to overweight home country equities at the expense of the world.  When investors are familiar with something, they over-allocate.  It is the same familiarity that leads employees to overweight company stock.  It is easy to see perverse examples from countries with small GDP.  Several studies of individual Canadian investor portfolios’ found that while Canada contributes less than 3% to global market capitalization, most Canadian investors have between 40-50% of their equity portfolios in Canadian equities.

The US makes up about 44% of the world market capitalization and most US investors have between 75-85% of their equity allocation in US equities.  (Portfolio studies from 2004 by the US Treasury and the Federal Bank of New York showed an average foreign stock weight of only 15% for the average US investor!)  Is this an efficient way to invest?  No.

What is an appropriate weight to foreign equities for a US Investor?  The first and obvious approach looks at portfolio optimization and overall portfolio risk (volatility).  S&P, Fidelity and MSCI all agree based on their data and research conclusions that an optimal portfolio of stocks for a US Investor should have 30-50% invested to foreign stocks for US investors.  A quick review of some of the largest target-fund families indicate the shift isn’t on yet…  Interestingly, Fidelity still maintains a ratio of 4:1 US to foreign stock weight despite publishing comments and citing their own studies that show a higher foreign weighting would be beneficial.

Ratio of US to Foreign Stocks by Target Fund Date

How Much International Reduces Risk the Most?

Volatility of S&P 500 / EAFE Stock Mixes

A second way to determine foreign exposure is to use a market capitalization weight.  Basically, this is all the stock markets that an investor can access.  This puts the US at around 44% which slightly out of the optimal range noted by the above charts.

A third way is to weigh foreign stock exposure by GDP adjusted for Purchasing Power Parity (PPP)  This would reduce the US exposure to about 21%:

Top 45 Countries Ranked by GDP

A fourth and more aggressive approach would be to use projected country GDP growth rates and how they contribute to overall global growth in the next 20 years.  This would cause you to overweight the Emerging Markets at the expense of the developed US and Western European markets at about a 3:2 ratio ultimately leaving the US around 15% of a stock portfolio weight.  That is obviously a low allocation for a US investor but does put the US’s declining world contribution to GDP in perspective and highlights how ridiculous it is for US investors to have an 85% equity weighting to the US.

About Matthew Kolesky

Matthew Kolesky is a Principal at ACM, Inc. and joined the firm in 2004. Matthew Kolesky was born and raised in Alaska and has served on many Anchorage area non-profit boards.